Higher Sin Tax: Bigger Revenues, Less Consumption

Sta. Ana coordinates Action for Economic Reforms. This piece was published in the September 12, 2011 edition of the BusinessWorld, pages S1/4 to S1/5.

A hefty increase in sin taxes to simultaneously meet health and revenue objectives cannot be done at the same time. Right or wrong?

Representative Hermilando Mandanas, chair of the Lower House’s Ways and Means Committee, thinks that a much higher tax on tobacco can reduce smoking consumption, thus good for health. But it will result in lower revenues for a cash-strapped government. His argument is simple—higher tax (price), less smoking (and less demand for tobacco products) leads to lower sales and therefore lower tax collection.

Smart man that he is, he omits the important point that though some smokers will quit arising from a much higher tax (and equally important, a higher tax can prevent heretofore non-smokers from taking up the habit), other smokers will continue smoking precisely because of the addictive nature of tobacco. Or for those intending to stop smoking because the price is becoming unaffordable, kicking the habit for them can take a longer time. Thus, for the short term, their consumption of cigarettes will continue.

This is a good example of inelastic demand. The increase in the tax (and the price) will not deter some from consuming the product. In other words, the rise in the tax (for example, expressed in terms of percentage) does not result in a corresponding percentage decrease in demand. The decrease in demand is more than offset by the significant increase in the tax (price). Therefore, the increase in price, despite demand reduction, still leads to higher total revenues.

Based on the price elasticity estimate of the Department of Finance for tobacco products (approximately -0.5), a 10 percent increase in the tax will decrease demand by five percent.

The sin tax bill that Malacañan has endorsed to Congress will substantially increase the tax rates along with simplifying the tax structure and indexing the specific excise tax to inflation.

To illustrate, in 2012, the specific tax on distilled spirits will be pegged at PHP42.00 per proof liter for products with less than 45 percent alcohol by volume, followed by annual increases reaching PHP159.14 per proof liter in 2016.

For fermented liquor, the tax rate for all brands, regardless of price, will unify at PHP25.00 per liter in 2012. The tax rate will increase incrementally per year, reaching PHP 28.14 per liter in 2016.

For tobacco products, the tax rate for high-priced cigarettes (with a net retail price of over PHP 10.00 per pack) and lower-priced cigarettes (with a net retail price of less than PHP10.00) will increase to PHP30.00 and 14.00 per pack, respectively, in 2012. By 2014, the tax rate for all cigarette brands regardless ofprice, will unify at PHP30.00 in 2014, to be followed by gradual increases, with the unified tax rate set at PHP 31.83 in 2016.

All told, the total cumulative revenues to be generated from the sin tax reform will amount to more than PHP530 billion pesos in six years (2012-16). For the first year alone, the revenues to be collected will reach PHP 60.63 billion pesos, half of the amount to be contributed by the tobacco taxes.

Furthermore, health objectives will be satisfied. We can expect a reduction of approximately two percentage points in smoking prevalence, and we can generate substantial funds to finance the government’s program for universal health coverage.

The evidence is clear that a significant increase in sin taxes will result in higher revenues and better health outcomes. It is worth reciting the recent experience in Ukraine.

From January 2007 to December 2010, the nominal value of the excise tax for a filtered cigarette pack rose from UAH (Ukrainian Hyrvnia) 0.38 to UAH 3.47. In terms of real value, with January 2007 as base, the specific tax rate increased from UAH 0.38 to UAH 2.00.

This “dynamic tax policy,” as described by Hanna Ross et al. (2011) led to a fall of cigarette consumption by 13 percent in 2009 and 15 percent in 2010. Moreover it resulted in an increase in tax revenue amounting to US$700 million in 2009 and US$500 million in 2011. For further scrutiny, read Economic and public health impact of 2007-2010 tobacco tax increase in Ukraine, co-authored by Hann Ross, Michal Stoklosa, and Konstantin Krasovsky (2011).

We can expect a replication of the positive outcome from the Ukrainian experience elsewhere, including in the Philippines. The explanation is that sin products have the feature of demand inelasticity. In the case of products that have price- inelastic demand, a well-designed high tax rate will still yield substantial revenues and at the same time satisfy health considerations.

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Erratum: Here is the corrected statement from last week’s Yellow Pad column (5 September 2011): “Ukraine’s ‘dynamic 2007-2010 tax policy,’ in which the real value of the excise tax increased five-fold (400 percent!), resulted in an increase in revenues by US$700 million in 2009 and US$500 million in 2010.” The five-fold increase is equivalent to a 400 percent increase.